The Real Cost of "No Cost" Mortgages

One of my Realtor® clients called me last week. "Aaron, I want to refer my client to you but they say they have another mortgage lender in Las Vegas who is offering them a 'no-cost' loan and they don’t have to pay any closing costs. Is this real? Can you match it?"

The answer is "Yes, I can match it." The bigger question is "Are they sure this is what they want?"

First of all you need to determine what they are being promised. Most lenders who offer “no-cost” mortgages are talking about their lender fees, not those fees associated with title, escrow, taxes, reserves, impounds, prepaid interest, etc. Led by Internet lenders, the term "no-cost" mortgage is something we now hear all of the time. (It's kind of like when short sale agents list homes for sale in Las Vegas way below market value to generate a bidding war. The final cost is always more than the initial offering. Check out current Las Vegas MLS listings for sale.)

As you know, not many things are free. This is no exception. There is simply no such thing as a "no-cost" mortgage. Mortgage companies are obviously not in the business of doing free loans. You will always pay your closing costs one way or another.

OK, so then how do they do it?? If you don't pay your closing costs in cash at the closing, you are simply going to pay it in the future by accepting a larger loan amount or an above-market interest rate.

For example: There are some banks and brokers that offer programs like 107% financing. You have seen the billboards and ads. This means if the home you are buying is $300,000, they will loan you up to $321,000. Obviously, this more than covers all of your closing costs, including your impounds, reserves, taxes, title, escrow fees, etc.

On average, closing costs, including everything I just listed, are around 2.5-3.0% of the loan amount. Lender's fees usually average about 1.0-2.0% of this total amount.

IMPORTANT NOTE: Special circumstances can make both of these "average" numbers I just quoted much higher.

It sounds great!! You don't have to pay one dime out of your pocket!! However, these products almost always carry a much-higher interest rate and the loan products are limited. You are not likely going to get a 107% loan on an interest-only ARM. In addition, you are going to pay $10,000's, if not over $100,000, of additional interest over the life of the loan simply because you did not pay cash for the closing costs.

The next way to get you a "no-cost" loan is by the broker or bank raising your interest rate to a higher level than you would normally get if you were paying the closing costs yourself. They get a bigger fee and pay your closing costs for you. It may sound great but it's usually a bad financial decision and the advertisers of the "no-cost" mortgage rarely give you the details.

This does not mean I am against "no-cost" mortgages. On the contrary, I believe in some situations they may be the only way to get the deal done. In that regard, it can sometimes make sense. However, it is important to understand what you are getting into. Same thing when you are determining what Las Vegas neighborhoods you want to live in. You need to factor in the lifestyle offered, not just the cost of the home itself.

Remember mortgage brokers find someone to loan you the money to buy your home. They collect a fee from this party when they complete the transaction. The fee they collect is called a “Yield Spread Premium.” In order to pay your settlement charges on a “no-cost” mortgage out of this fee and have enough left to compensate himself, the broker will need to make sure the fee he collects is big enough to cover all of these charges. Keep in mind, in this scenario, we are not likely talking about third party fees like escrow, title, and taxes nor are we talking about prepaid interest charges, impounds and reserves. We are just talking about the lender's fees. To get a "no-cost" mortgage will usually mean a higher interest rate to you to increase the size of his fee from the lending bank to make sure he covers your costs and his fee.

Mortgage bankers, like here at Realty Mortgage, deal directly with borrowers. We often have the ability to do the same thing, except there is no YSP. In certain situations, we may be able to increase your rate in order to help you cover the costs associated with closing and to offer you a “no-cost” loan. However, we rarely recommend that you do this.

Rates are always changing. Therefore, it is difficult to give you a very firm example of the additional costs associated with this. Most lenders would agree with me that you can probably expect to pay an interest rate of .500%-2.000% higher on your loan if you want your closing costs covered. Sometimes it can be less. It will always be higher than if you were paying these costs yourself.

On a $300,000 loan, the difference between 6.000% and 7.000% is around $200/mo. If the lender's fees on this loan were on the high side of $4500, it will take you 23 months of this payment for this to be a negative situation for you and your family. You have 307 months to go and this does not include the additional interest compounding. The amount of money this costs you can be even more dramatic if you are looking at luxury homes for sale in Las Vegas.

The bottom line is go with your instinct. You know there are no free rides and there is not one here either. Borrowers usually pay handsomely pay for a "no-cost" loan by accepting a higher interest rate than they would if they paid their own closing costs. Once again, some of the loan programs that would be available to someone paying their own closing costs may not be available.

Most lenders and financial advisers agree that “no-cost” loans, unless you plan on being in that home less than two years, make very little sense.

If you don't have access to the money required to close, and you have no way of borrowing it from a family member or someone close to you, and you are absolutely in love with the home, then consider it. Just keep in mind, that "no-cost" loans are usually a bad long-term financial decision, and you are likely going to pay a premium price for this decision.

Las Vegas real estate agents should understand the best way for you to help your "cash-strapped" client in this situation is to aggressively negotiate some closings costs from the seller. Obviously this works best in a buyer's market like we are experiencing now then in a seller's market like the one we dramatically experienced throughout most of 2004.